Where do Banks Buy & Sell in the FX Market?
You have your trading account with a regulated broker that informs you their pricing is coming from major tier 1 Banks. If you are trading on an ECN, or STP, model with your broker you are told that your trades are being directly executed with an LP (Liquidity Provider) – often called an Agency Model. So where does the LP go to trade?
Long before the advent of margin trading there has existed the Interbank FX market. As the name implies this market is available for Banks (and more recently non-banks such as Funds and Algorithmic Trading Companies). The Interbank FX market allows participants to trade directly with one another or trade through an Over The Counter (OTC) electronic brokerage platform.
The 2 major OTC incumbents are EBS (Electronic Broking Service – owned by ICAP) and Reuters Matching both launched in the mid 1990’s. Both of these platforms connect over 1000 Market Participants and “turnover” combined volume in excess of $300 Billion per day. So when you are trading on an ECN (STP model of execution) it is highly likely that the LP you have traded with will hedge (offset) your trade in an OTC electronic venue.
There may be times when the LP is managing its risk and your trade with them “matches” off against its own trading position – this quite often get called “internalizing”.
There are also times when an LP is happy to take your trade and “warehouses” the risk as they believe the market is moving in the opposite direction to your trade.
LP’s can also hedge (offset) trades via an exchange such as the CME or CBOT – trading a Futures contract and converting it into a “synthetic” spot.
So that’s now….. But now for a brief history lesson……
Prior to the launch of electronic platforms Banks would trade with one another via:
A Voice Broker: In the heady days of FX there were several Voice Brokers in all the major financial centers around the world. Brokers would sit around large circular desks with a bank of phones in front of them connected to their local banks. Akin to open outcry a Bank would tell his broker his interest – “I want to buy 5 MIO at 20” the broker then repeats this to his colleagues around the desk in the hope that they would find a “seller of 5MIO at 20” or someone who was willing to sell at a slighter higher price. In this case a Bank would say “I offer 3 MIO at 23”. The broker now has a price 20-23 5MIO by 3MIO. The brokers would broadcast this price to their clients until, hopefully someone would “hit” the bid or “pay the offer”. If trade was done both counterparties would be told by their broker: “You bought 5 MIO at 20 from Bank XXX” and the other side of the trade would be told “You sold 5 MIO at 20 to Bank YYY”. The whole process would start over again with the brokers asking their banks for a price or to “show their interest”. Having been a Voice Broker myself for over 20 years I can honestly say that this method of trading was fast paced and very efficient (in its day). Brokers were “middle men” who “charged” a small commission” for their service. Typically, this would be a few $ per MIO traded. I know it does not sound like a lot but if a typical broking desk was turning over 5+ Billion a day – you can do the math’s that this was a highly lucrative business. Sadly, the arrival of electronic trading resulted in the majority of these Voice Brokers going out of business – although there are still a few around today that service Banks in Shorts, Forwards, Outrights, Options and some spot FX.
By Phone: I know it sounds crazy but, believe it or not, one Bank would call another Bank and ask for a price in a specific currency and a specific amount. Bank A would quote Bank B the price and Bank B would either trade or “Pass” or “Regret”. This method was often used when a Bank had a large order they wanted to “finesse” – not going through a broker made it difficult for the quoting Bank to know what was going on. It allowed the Banks asking for a price to trade with many counterparts simultaneously and move very large amounts stealthily. Whilst still used as a trading method between a Banks client and itself most Banks rarely trade with each other this way as it has become more inefficient with the plethora of electronic venues available to them.
By Conversational Dealing: Well before the advent of the internet and instant messaging Reuters developed a messaging service for its FX clients. This was called Conversational Dealing or Reuters Dealing. Reuters utilized the global network that was used by Air Traffic Controllers to “piggy back” Reuters Dealing. Dealing allowed a Bank to call another Bank within the Reuters Dealing network via a 4 letter Dealing code. Back in those days every bank had a Dealing Terminal and would receive calls from other Banks requesting a price. Similar to instant messaging you had to take turns “talking” with each other and Dealing abbreviations were frequently used. Bank ABCD would call Bank WXYZ and ask for “Cable in 5 pls”. Bank WXYZ would see the message and know that Bank ABCD is asking for a 2 way (bid and offer) in GBPUSD in 5 MIO GBP. Bank WXYZ would type in 20-25 and hit transmit. Bank ABCD would see 20-25 on his screen and could then trade or pass on the price. If he was a seller he would simply type 5 yours and transmit. Bank WXYZ would see the message 5 yours and he would know that Bank ABCD was selling him 5 MIO GBP at 20 (“yours” as used as a way of saying “I sell” conversely “mine” was used to signify “I buy”). Bank WXYZ would normally then respond back with “I buy 5 mio gbp at 1.6520 tks and bbfn” (tks=thanks and bbfn= bye bye for now). In its heyday Reuters Dealing was one of the most often used methods of trading and still is in use today.
Any way you look at it the LP’s pricing you through your broker have multiple venues/ways to offload risk in a market that has average daily volumes in excess of 5 Trillion USD!!!
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